China Investor Comes Clean

Zack Buckley is an external contributor to TheStreet whose commentary is unrelated to TheStreet's news coverage.

To his credit, out of all the major figures (Alan Greenspan) was the only one who promptly said 'I was a horse's ass' ... I think we need more of that sort of thing. -- Charlie Munger

NEW YORK ( TheStreet) -- Over the past two years, I have not only been buying and recommending Chinese companies to other investors, but I have also had a substantial amount of my own portfolio invested in Chinese companies listed on U.S. stock exchanges.

Many of these companies seemed like an investment opportunity of a lifetime, so I set out on a trip to China in an effort to understand them better and confirm that they were indeed excellent investment opportunities run by honest, capable Buffett-type managers. Instead, my trip had the opposite result.

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After spending two months in China visiting 50 publicly traded companies listed on the U.S. markets, my thoughts on investing in China have changed drastically. It is tough to admit when you've been a "horse's ass," but I believe my own investing in China and recommendations of Chinese stocks have made me exactly that.

As a value investor, I only invest when I feel I have a solid understanding of the company and that the company is worth substantially more than its current market cap. Before my visit, I knew that I did not understand the Chinese companies as well as I would a company in the U.S., but I felt that the valuation of the Chinese companies, as well as a basket approach to ownership, would more than compensate for this risk. I now feel that investment approach is deeply flawed.

I discovered that American investors generally have little to no understanding of what is actually happening in the Chinese companies that they own for two main, interconnected reasons: Not only is business in China more likely to be fraudulent (as most native Chinese citizens will tell you), but American professionals also are not protecting U.S. shareholders the way they should be.

In China, I visited company after company that had substantial problems in their business models or had completely unpredictable future cash flows, which was not what American investors had been led to believe. These problems were compounded by the fact that there are fraud accusations against a number of these companies that seem to be well researched with sound logic and reasoning.

For example, I visited a company that was supposed to generate $20 million in revenue for the most recent fiscal year, but when I saw its physical tax statement from the Chinese provincial government, it stated that it had made only $100,000.

In another instance, a well-known Chinese company raised $75 million based off of the value of its retail stores, but a private investigator later verified that a vast majority of these stores did not exist. A friend of mine in China told me that he knew someone who had visited a company that was a fully operational factory the day he visited. When he drove by the next day, the factory was shut down and the gate was padlocked. He asked some of the locals what they knew about the factory, and they told him it was always closed.

This case certainly should serve as a warning to investors, though I think it is unusual. All of the companies I visited definitely had operating entities, so I do not believe that any of these companies are complete frauds.

In most cases, if a company is a fraud, it is exaggerating the size or profitability of its operations, such as in the two examples above. Clearly, China can be a dangerous place to invest: Not only are some Chinese companies intentionally misleading American investors, but the American professionals who collect their hefty fees on offerings like these clearly do not conduct proper due diligence.

Unfortunately, we cannot always trust in the "due diligence" that auditors, investment bankers, investor relations firms and lawyers perform on these companies. Some auditors have proven very unreliable, because an analyst thousands of miles away from a Chinese company can find glaring inconsistencies in financial reporting that auditors were not able to find on site in China, like in the case of the retail stores.

Because these professionals make a living off of the proliferation of Chinese companies in U.S. markets, they have a strong incentive to believe and convince others that these companies are all honest.

But behind closed doors, many of these professionals admit that they will never invest their own money in these companies, yet they are willing to allow thousands of other investors to do so. This is not to say that all professionals intentionally mislead their clients; there are plenty of trustworthy professionals in the industry, but a few bad apples mean that the onus is on you to know and trust the professionals you work with.

Additionally, American shareholders may even lose their money invested in a legitimate Chinese company. Recently, the Chinese management of a company I used to follow attempted to throw out the American board members and delist their company, in which case the value of the company for American shareholders would go to zero.

If the Chinese board members succeed, they will essentially steal the Chinese company from U.S. shareholders. Even though this particular company was not a fraud, and in fact, has substantial and impressive modern operations, American shareholders may still lose their entire investment. I strongly recommend reading Tim Clissold's Mr. China, in which he details several similar experiences of American investors losing their money in legitimate Chinese companies.

After my trip to China, I have sold off nearly all of my China holdings, though I still hold a few small positions. There are legitimate companies and great investments in China, but it is so difficult to distinguish between the legitimate businesses and the frauds that I am not interested in playing the game. Since I have been so bullish in the past, I want to make it clear that I may begin to short some companies that I find to be potentially fraudulent. I think it is less risky to make money shorting these Chinese companies.

I changed my investment approach, because even after I conducted my own due diligence by visiting these companies, meeting with the management and touring the facilities, I feel that I do not have a strong enough understanding of these companies, nor do I feel comfortable with most of the businesses I was buying previously. I would caution investors not to overestimate your understanding of these companies, as I did in the past. Reading the SEC filings and taking them at face value is not adequate due diligence on these companies.

Warren Buffett is famously quoted as saying, "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy." In China, countless frauds have proven consistently that American investors are the patsies in the investment game.

As a poker player myself, I know when I am the patsy in a game, and that the best decision for my money at that point is simply to leave the game. During my trip in China, I realized I was the patsy investing in these companies, and so I am quitting this game.

Zack Buckley is general partner for Buckley Capital Partners Hedge Fund and manages his blog at Uncoveringalpha.com. He developed his investing methodology by synthesizing the ideas from the best investors of all time: Warren Buffett, Peter Lynch, Seth Klarman and Benjamin Graham. He can be contacted at Zack@buckleycapitalpartners.com

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